The outlook for services inflation in the United States and the United Kingdom

Prepared by Filippo Arigoni, Baptiste Meunier, Isabella Moder and Adrian Schmith

Published as part of the ECB Economic Bulletin, Issue 1/2025.

While headline inflation has decelerated significantly across advanced economies in the past two years, services inflation has remained high. Since peaking in mid-2022, headline inflation in advanced economies (excluding the euro area) has declined significantly, supported mainly by falling or negative contributions from energy and core goods prices (Chart A). At the same time, services inflation has remained high, representing by far the largest component of headline inflation.^[1] This box analyses the main drivers of services inflation in the United States and the United Kingdom, disentangling services inflation excluding rents from rent inflation, as they follow different dynamics. Specifically, the box highlights the role of labour market tightness and catch-up dynamics in non-rent services inflation.^[2]

In the case of non-rent services inflation, empirical analysis suggests that wage growth has been a key driver. The results of an econometric analysis indicate that wage inflation has generally been the main driver of core services inflation excluding rent (Chart B).^[3] Input prices also played an important role in the strong rise in services inflation in 2022 and 2023, when producer prices inflation was pushed up by supply bottlenecks and large energy shocks, reaching levels twice as high as before the outbreak of the COVID-19 pandemic.^[4] However, as input price pressures have receded on the back of a strong deceleration in producer price inflation, nominal wage pressures have become the main driver of services price inflation. The sources of inflationary pressures have thus shifted away from global and towards domestic factors, reflecting second-round effects as nominal wages start to catch up with inflation.^[5] This is consistent with persistently high nominal wage inflation in the United States and the United Kingdom, which stood at 3.9% and 5.3%, respectively, in the second quarter of 2024, and the persistence of services inflation, despite downward pressure stemming from other factors.

Labour market tightness and catch-up dynamics have been the main contributors to the post-pandemic acceleration of wage growth and its recent moderation. An examination of the factors underlying nominal wage inflation suggests that a large part of wage growth developments in the United States and the United Kingdom can be attributed to labour market tightness and lagged inflation, reflecting second-round effects as nominal wages catch up with previous inflation (Chart C).^[6] In the United States, both labour market tightness and high inflation rates have contributed to the acceleration in wages since 2021. After the peak in mid-2022, wage growth started to decline again, equally supported by a softening of labour market tightness and lower inflation. By contrast, in the United Kingdom the timing of the contributions of these two factors to wage growth was different. Labour market tightness played a strong role in the initial wage acceleration after mid-2021, mainly owing to UK-specific conditions, such as a decline in the labour force driven by increased long-term sickness and Brexit-related labour shortages.^[7] Lagged inflation, probably linked to second-round effects, started to play a more prominent role in the second half of 2022. Since late 2022 and early 2023, labour market tightness has started to ease, while lagged inflation has remained the main driver of wage growth above pre-pandemic levels.^[8]

Forward-looking indicators point to a moderation of wage growth. The Indeed Wage Tracker is generally considered a leading indicator for wage growth as it is based on pay offers included in new job ads online. The latest data from the tracker point to a decline in wage growth for the United States and a stabilisation at relatively high levels for the United Kingdom (Chart D). In the third quarter of 2024, the Indeed Wage Tracker for the United States was in the range of 3 to 3.5% for the third consecutive quarter, showing signs of stabilising at its pre-pandemic level. In the United Kingdom, the tracker has stabilised at an annual growth rate of 6 to 7% for the last three quarters. Hence, while the actual nominal wage growth series in the United Kingdom is showing clear signs of gradual disinflation (Chart C), and forward-looking business surveys point to a moderation, there remains some uncertainty around the extent of the moderation, as suggested by the unchanged value of the Indeed Wage Tracker. The latest readings of the ratio of vacancies to unemployment, an indicator of labour market tightness, also exhibited substantial signs of easing and a return to pre-pandemic averages for both countries. This is consistent with a likely, albeit delayed, cooling of UK wage inflation going forward.

In addition, rent inflation accounts for a non-negligible part of services inflation in the United States and the United Kingdom. Rent inflation (excluding owner-occupied housing) accounts for 12% and 16%, respectively, of US and UK services inflation.^[9] Rent inflation tends to exhibit strong persistence, since only new contracts and agreements renegotiated for contractual reasons affect the stock of rental agreements. Hence, large inflationary shocks – such as seen in recent years – pass through to overall rent inflation only with a lag. From 2021, rent inflation lifted off in the United Kingdom and even more so in the United States, where it appears to have peaked in mid-2023 (Chart E). Data from independent rental brokers on new rental agreements, which show a high correlation with one-year-ahead CPI rent inflation, suggest that, in the near term, rental inflation should decrease further in the United States and start easing in the United Kingdom.

A moderation in wage growth and rent inflation should bring down services inflation, although the pace of disinflation remains uncertain. Forward-looking indicators are pointing to a deceleration in wage growth and rent inflation amid still restrictive monetary policy in both jurisdictions. Should wage growth and rent inflation decelerate in the near term in line with these forward-looking indicators, UK and US services inflation can be expected to decrease. However, the pace of disinflation remains uncertain, and more persistent than expected services inflation could be fuelled by enduringly high wage growth, particularly if the labour market remains tight or if workers continue to make high wage demands in response to the erosion of real wages by past inflation. Moreover, structural shifts in wage and price-setting behaviour might have contributed to the recent inflationary persistence and might continue to do so in the period ahead.^[10]